Sec. 382 provides an annual limit on the amount of NOLs and other loss or credit carryforwards a corporation can use after it undergoes an ownership change. The annual limit is determined by multiplying the value of the corporation by the long-term tax-exempt rate for the month of the ownership change (this rate is published monthly by the IRS and is 1.77% for October 2019). An ownership change occurs if the corporation’s significant shareholders, each owning 5% or more of the value of corporation, increases their collective ownership by more than 50% over a specific testing period, generally, a rolling three-year period.
In addition, if the fair market value of a corporation’s assets exceeds the assets’ tax basis, it has a net unrealized built-in gain (NUBIG). In that case, the Sec. 382 annual limit is increased for any built-in gains recognized (RBIG) in the five years after the ownership change. Conversely, a corporation with a net unrealized built-in loss (NUBIL) in its assets will have any recognized built-in losses (RBILs) in the five years after the ownership change subjected to the same annual limitation as its NOLs and other attributes.
The only guidance the IRS has previously provided for taxpayers to determine NUBIG/NUBIL and RBIGs/RBILs is Notice 2003-65. That guidance provided two alternative safe harbor methods that taxpayers could follow to make these determinations. This flexibility allowed taxpayers with NUBIGs to select methodologies that maximized the benefit of RBIGs and taxpayers with NUBILs to select methodologies that minimized the detriment of RBILs.
If the proposed regulations are adopted in their current form, they will make key changes to the built-in gain and loss rules with the primary goal of creating more consistency among taxpayers. However, these changes are almost uniformly unfavorable to taxpayers. The key changes include:
- Mandatory use of the Sec. 1374 method – The proposed regulations remove the flexibility that taxpayers had under Notice 2003-65 and require all taxpayers to follow one uniform methodology. The methodology dictated by the proposed regulations is highly unfavorable to corporations with NUBIGs by severely limiting the RBIGs that will be treated as increasing the annual limitation. In effect, taxpayers will only be able to generate RBIGs by actually disposing of assets at a gain within the five years after an ownership change. Under Notice 2003-65, taxpayers could be treated as having generated RBIGs without actually realizing taxable gains, thereby permitting NOLs to offset operating income generated in periods after the ownership change.
Example: TechCo is worth $60 million and experiences an ownership change, subjecting it to a Sec. 382 limitation at a time when the applicable federal rate is 2%. This will create an annual limitation of $1.2 million. TechCo has $20 million of NOLs, has no tax basis in its assets, and all of its value is attributable to intangible assets.
Under previous guidance, TechCo would have the capacity to use $5.2 million of NOLs each year for the first five years, and $1.2 million per year thereafter. Therefore, all NOLs would be completely free of limitation within four years of the ownership change.
Under the proposed regulations, the utilization of NOLs would be only $1.2 million per year unless TechCo actually sells its intangibles in a taxable sale. As a result, it would take 17 years (an extra 13 years!) to be able to use all the NOLs carryforwards. Some of those NOLs generated in years prior to 2018 may have already expired by the time they become utilizable.
- Contingent liabilities treated as RBILs – Under Notice 2003-65, corporations with contingent liabilities have flexibility to choose a methodology that wouldn’t treat any deduction eventually arising from a contingent liability as RBIL. The proposed regulations mandate that all contingent liabilities would be treated as RBILs if they become deductible within the five years after the ownership change. This is highly unfavorable to corporations with NUBILs.
Example: ManufacturerCo undergoes an ownership change at a time when it has a NUBIL, and has a contingent liability for pending litigation. At the time of the ownership change, the estimated value of the liability is $10 million. Within the five years after the ownership change, the litigation is settled for $15 million. Under Notice 2003-65, ManufacturerCo would be able to select a methodology where any deduction resulting from the contingent liability wouldn’t be treated as an RBIL because the liability was not deductible at the time of the ownership change. However, under the proposed regulations, ManufacturerCo would be required to treat $10 million of the $15 million settlement as an RBIL.
- Reduced NUBIG for insolvent corporations – Under Notice 2003-65, insolvent corporations generally have a NUBIG at least equal to the amount of the insolvency. However, under the proposed regulations, the NUBIG calculation would change in a manner so that NUBIG/NUBIL calculations will be based solely on the difference between the value and tax basis of the corporation’s assets. This will generally have the effect of reducing the NUBIG of insolvent corporations (or pushing them into a NUBIL position).
If you have any questions, please contact your tax advisor.